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I am a beginner finance student, i am having trouble understanding short sale.In this context the bond is priced at 960.00 and will give a future payment of 1000 1 yr from the day it was bought. enter image description here

I don't quite understand how one can obtain arbitrage profit if he or she does not own the security.Could someone tabulate the strategy to help me understand this ?

Any help is greatly appreciated ! Thanks

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Borrow the overpriced bond promising to repay the lender $1000 in one year. Sell the bond immediately for $960. Put $952.38 in the bank where the it will gain enough to be worth $1000 in one year. You have +$7.62 immediate cash flow. In one year repay the bond lender with the $1000 from the bank.

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  • This is the most concise answer. The one piece that maybe is not clearly stated is that you only have to put $952.38 in the bank because the bank is offering an interest rate that will turn that amount into $1000.00 in a year. The last thing you want to do is pay money out of pocket to cover your short position. Of course, this example is very simple. In reality, you'll have to factor in things like trading costs (usually for bond sales it's rolled into the price of the bond by the brokerage), and taxes. – Kent A. Feb 28 '15 at 15:37
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Investopedia has a good explanation of the term shorting which is what this is. In the simplest of terms, someone is borrowing the bond and selling it with the intent to replace the security and any dividends or coupons in the end. The idea is that if a bond is overvalued, one may be able to buy it back later for a cheaper price and pocket the difference. There are various rules about this including margin requirements to maintain since there is the risk of the security going up in price enough that someone may be forced into a buy to cover in the form of a margin call.

If one can sell the bond at $960 now and then buy it back later for $952.38 then one could pocket the difference. Part of what you aren't seeing is what are other bonds doing in terms of their prices over time here. The key point here is that brokers may lend out securities and accrue interest on loaned securities for another point here.

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  • Thank you for your answer , I am a bit confused how one can execute short selling in this example.Say i burrow the security then i would need to return it to the person i have burrowed. Given that the portfolio in the example gives a current net cash flow of 7.62, buying the security at current cash value x (discounted to the current time) to return it to the original owner would mean the net cash flow at the current price is 7.62-x. Is it realistic that 7.62-x > 0 ? – LightY Dec 30 '14 at 3:42

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